Audit committee perspectives on mandatory audit firm ...

J Manag Gov DOI 10.1007/s10997-015-9308-2

Audit committee perspectives on mandatory audit firm rotation: evidence from Canada Richard Fontaine • Hanen Khemakhem David N. Herda

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Springer Science+Business Media New York 2015

Abstract This study examines audit committee (AC) members’ perspectives on mandatory audit firm rotation (MAFR), mandatory audit partner rotation, ways in which ACs monitor auditor independence and objectivity, and the costs associated with switching audit firms. In-person interviews with AC members in Canada were conducted to improve our understanding of the reasons underlying AC members’ positions on MAFR. All AC members interviewed in this study were adamantly opposed to MAFR. MAFR was perceived as a threat to their shareholder-granted authority to make audit firm appointment decisions. Participants believe that their professional judgment and observations are the most effective means of ensuring auditor independence and view MAFR as an unnecessary intervention. We explain these results using self-determination theory. Our findings were also used to develop a conceptual model of AC relationships with external auditors and financial management. Keywords Mandatory audit firm rotation Audit committees Auditor independence Self-determination theory Canada

R. Fontaine (&) H. Khemakhem Department of Accounting, ESG-UQAM, Case postale 8888, succursale Centre-ville, Montreal, QC H3C 3P8, Canada e-mail: [email protected] H. Khemakhem e-mail: [email protected] D. N. Herda College of Business, North Dakota State University, PO Box 6050, Fargo, ND 58108-6050, USA e-mail: [email protected]

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1 Introduction Mandatory audit firm rotation (MAFR) has received a great deal of attention in recent years, due in part to a concept release from the Public Company Accounting Oversight Board (PCAOB) requesting comments on the advantages and disadvantages of MAFR (PCAOB 2011). Although the adoption of MAFR in the U.S. is unlikely, MAFR is being implemented in Europe (Tysiac 2014).1 MAFR was required for banks in Canada until 1991 when it was abolished in favor of mandatory partner rotation (GAO 2003). Arguments for and against MAFR are well documented (Stefaniak et al. 2009). Proponents of MAFR argue that long-tenure relationships between audit firms and clients can lead to audit failures due to high levels of familiarity that impair auditors’ independence and professional skepticism (e.g., Moore et al. 2006; Gavious 2007). Opponents of MAFR argue that long-tenure auditor–client relationships lead to valuable client- and industry-specific knowledge over time resulting in enhanced audit quality (e.g., AICPA 1992; BDO 2003; Arrunãda 2000, 2004). A number of academic studies examine whether MAFR improves auditor independence and audit and financial reporting quality, reporting mixed results (Casterella and Johnston 2013). However, most research on MAFR provides little evidence that it is effective in improving audit quality (DeFond and Francis 2005; Stefaniak et al. 2009). The audit committee (AC) plays an essential role in corporate governance (Dobija 2013). The AC is responsible for the appointment, compensation, and oversight of external auditors.2 Interview studies involving external auditors (Cohen et al. 2010) and AC members (Gendron et al. 2004; Beasley et al. 2009) indicate that the importance of the AC’s role in monitoring auditors and financial reporting quality has increased in the post-SOX period. Understanding AC perspectives on auditor independence and objectivity is critical since the AC is charged with overseeing financial reporting and disclosure. ACs are authorized to make audit firm selection decisions and could voluntarily implement a firm rotation program if they so desire. Most AC members oppose MAFR (Ernst and Young 2012). Explanations behind AC opposition to MAFR were previously limited to information found in formal comment letters sent to the PCAOB. The primary purpose of this study is to investigate Canadian AC members’ perspectives on MAFR. We endeavor to improve our understanding of the underlying reasons behind the positions of AC members on MAFR. This study also examines how AC members currently ensure auditor independence and objectivity and how AC chairs maintain and monitor a series of important relationships including the AC-external auditor relationship, the AC-financial management relationship, and the external auditor-financial management relationship. Finally,

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Beginning in 2016, European-listed companies, banks and financial institutions will be required to appoint a new auditor every 10 years, though this can be extended if companies put their audit contract up for bid at the 10-year mark or engage another audit firm in a joint audit.

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See Sarbanes–Oxley Act (SOX) Sect. 301 (for U.S.) and NI 52-100 (for Canada).

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this study explores AC members’ views on the costs associated with switching audit firms. This paper contributes to the literature by providing deep insight into AC members’ perspectives on MAFR using an in-person interview methodology (Patton 2002). Although most AC members in this study favor audit partner rotation, all 19 interviewees were adamantly opposed to MAFR. MAFR was perceived as a threat to their shareholder-granted autonomy and authority, and participants suggested that their own judgment and observations were a more effective means of ensuring auditor independence and objectivity. We explain these results using selfdetermination theory. Interview results are also used to develop a model of AC relationships with auditors and financial management. The remainder of this paper is structured as follows. Section 2 reviews relevant research and background information on MAFR to motivate our research questions, and also lays the theoretical groundwork for potential explanations of AC members’ views. Our research methodology is outlined in Sect. 3. Results are presented in Sect. 4, followed by a discussion of the results in Sect. 5. Finally, Sect. 6 concludes with an overview of the findings and a discussion of the study’s limitations and suggestions for future research.

2 Background and research questions This section is organized as follows. First, we review prior academic research on MAFR. Next, we discuss our Canadian research setting, review existing information on AC perspectives on MAFR, and present our research questions. Finally, prior literature on theory relevant to directors’ motivations is reviewed as a basis for understanding AC members’ perspectives. 2.1 Prior academic research on MAFR DeFond and Francis (2005) and Stefaniak et al. (2009) reviewed the literature and conclude that the majority of research on MAFR provides little evidence that MAFR is effective in improving audit quality. However, Casterella and Johnston (2013) reviewed 24 academic studies on MAFR and argue that results from studies involving mandatory (as opposed to voluntary) auditor switching offer support for MAFR. They contend that the studies of voluntary switchers that find a positive relationship between audit firm tenure and audit or reporting quality could suffer from self-selection bias in that many companies that voluntarily change auditors could already be troubled with poor reporting quality. Although we do not repeat these comprehensive literature reviews in our paper, we discuss several MAFR studies below for contextual purposes. Most existing studies on MAFR use archival data. Geiger and Raghunandan (2002) find longer auditor tenure to be associated with less audit failures, providing no evidence in support of MAFR enhancing audit quality. Johnson et al. (2002), Myers et al. (2003), Carcello and Nagy (2004), Ghosh and Moon (2005), and Chen et al. (2008) find that longer auditor tenure does not reduce financial reporting

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quality, indicating that MAFR would not lead to improved reporting quality. Chi et al. (2011) find longer auditor tenure to be associated with lower abnormal accruals but higher real earnings management, providing mixed evidence on the potential effectiveness of MAFR in reducing earnings management behavior. A few experimental studies on MAFR have also been conducted. Dopuch et al. (2001) and Jennings et al. (2006) find that auditor independence is enhanced when a MAFR policy is in place. Daniels and Booker (2011) also find a positive relationship between MAFR and auditor independence perceptions but find that perceptions of audit quality are unchanged with MAFR. Wang and Tuttle (2009) find MAFR to be associated with auditors who display less cooperative negotiation strategies with clients, lending some support for MAFR. Kaplan and Mauldin (2008) find that MAFR does not lead to enhanced perceptions of auditor independence after controlling for audit partner rotation. These studies report mixed results regarding the impact of MAFR on independence perceptions and audit and financial reporting quality. 2.2 The setting in Canada The Canadian setting is relatively unique in that MAFR was required for financial institutions until 1991 when it was eliminated due to a lack of cost-effectiveness (GAO 2003). Mandatory audit partner rotation is required (CPAB 2012). Regulations concerning the responsibilities of ACs in Canada are found in NI 52–110 (Canadian Securities Administrators 2004). Similar to US policies, the AC is responsible for selecting audit firms and compensation levels and for monitoring the work of the auditor and the resolution of any disagreements between the auditor and company management. External auditors report directly to the AC. Many public companies in Canada are cross-listed on US exchanges and are therefore subject to PCAOB standards.3 Recently, the Canadian Public Accountability Board (CPAB) and Chartered Professional Accountants of Canada assembled working groups to examine how audit quality could be enhanced and issued a report summarizing their conclusions and recommendations (CPAB 2013). The report concludes that MAFR would not improve auditor skepticism since there is not enough compelling evidence to support this claim and argues that new auditors may not have sufficient client- and industry-specific knowledge to conduct a quality audit. The report contends that changing audit firms should be an informed decision overseen by the AC as opposed to a regulatory requirement (CPAB 2013). The working groups recommend that ACs conduct a comprehensive review at least every 5 years with the objective of recommending retaining or replacing the audit firm.

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Canadian stocks represent the largest group of stocks listed in the US from a single country outside of the US (Eun and Sabherwal 2003).

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2.3 Existing information on AC perspectives on MAFR In response to the PCAOB’s concept release on MAFR, various stakeholders submitted *600 comment letters expressing their views on MAFR. AC members submitted the most letters (40 % of the letters), followed by chief financial officers (16 %). An overwhelming majority of AC members opposed MAFR, citing increased audit costs as well as the cost in management and AC time in bringing a new audit firm up to speed so it could perform a quality audit (Ernst and Young 2012). There was strong support among respondents to retain AC oversight of the auditor, with many commenting that the AC is in the best position to identify and engage the auditor that best meets the need of the company (Ernst and Young 2012). 2.4 Research questions Comment letters submitted by AC members provide some insight into AC perspectives on MAFR. However, signed two-page comment letters cannot provide the depth of perspective that in-person interviews (with guaranteed anonymity) elicit. We are unaware of any existing interview studies in the academic literature on AC members’ perspectives on MAFR. The PCAOB (2011) has called for research on the extent to which ACs have considered implementing an audit firm rotation policy, and, if applicable, reasons why they have not considered implementing such a policy. There is also a call for further research on AC responsibilities in overseeing the relationship between the external auditor and management (DeZoort et al. 2002). Accordingly, we propose the following research questions: 1. 2. 3.

What are AC members’ perspectives on mandatory rotation and how do AC members currently ensure auditor independence and audit quality? How does the AC oversee the auditor-management relationship? What are AC members’ perspectives on the costs associated with switching audit firms?

2.5 AC members’ motivations and self-determination theory Our research questions are entirely exploratory and we do not seek to confirm or refute hypotheses. Nonetheless, to expect participants to be supportive of MAFR would be insincere for the following reasons. MAFR is not required in Canada and virtually no ACs have implemented a voluntary firm rotation policy (Jennings et al. 2006). Nearly all AC members that submitted comment letters to the PCAOB are against MAFR (Ernst and Young 2012). AC members may oppose change because they believe that the status quo is working well, they are key players in the current situation, and they relish their authoritative ability to make audit firm selection decisions. Some scholars challenge the existing state of affairs, however, and believe that change is necessary (e.g., Mitchell and Sikka 1993; Sikka and Willmott 1995; Moore et al. 2006; Gavious 2007). Accordingly, the results of our interviews

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with AC members and analysis of their responses should be interpreted with a measure of sensible skepticism. A classic agency theory (Jensen and Meckling 1976; Fama and Jensen 1983) view of the audit committee as an independent monitor of management has been used to frame some prior studies on AC members’ motivations (e.g., Beasley et al. 2009; Dobija 2013). Other recent studies have used self-determination theory to explain directors’ motivations (Boivie et al. 2012; Guerrero et al. 2014). Selfdetermination theory is an integrated theory of total motivation that encompasses both extrinsic (e.g., pay) and intrinsic motivations (Deci and Ryan 1985, 2000). Boivie et al. (2012) characterize this theory as a middle-ground perspective between agency theory and stewardship theory. According to self-determination theory, the ability to influence is an intrinsic motivator that enhances one’s sense of autonomy and competence (Deci and Ryan 2000). The theory characterizes autonomy, referring to volition and freedom, as an innate human need: ‘‘This autonomous regulation contrasts with regulation based on coercive forces…that override important inner functions, sensibilities, and processes (Deci and Ryan 2000: 254). Using this theoretical framework, Boivie et al. (2012) posit and find that the ability to influence organizational outcomes is a significant reason why outside directors choose to serve on boards.4 Consequently, selfdetermination theory may be a useful lens with which to examine AC members’ motivations and interpret responses to research questions.

3 Research method To address our research questions, we used a qualitative approach with in-person interviews. We conducted 19 interviews—18 in person and one by telephone.5 We used professional contacts and referrals to gain access to participants. Participants are AC members of Canadian publicly listed corporations in Quebec or Ontario. Thirteen participants (68 %) are AC chairs. Participants’ average AC tenure is 8 years, ranging from a minimum of 2 years to a maximum of 15 years. We inquired as to their financial expertise. Nine participants (47 %) are professional accountants. Of the remaining 10 participants, six are MBAs, one is an economist, one is an entrepreneur, one is an administrator, and one holds a PhD in biochemistry. We did not note any significant discrepancies in response themes between chairs and regular members and across experience or financial expertise levels. To conduct the interviews, we used the general interview guide approach that is recommended when in-depth information is required (Patton 2002). This approach provides for the use of a questionnaire with open-ended topics that is helpful in 4

One of Boivie et al. (2012) proxies for directors’ ability to influence was whether the director is the AC chair. 5

Although in-person interviews are preferable, telephone interviews can be used productively in qualitative research (Sturges and Hanrahan 2004). No new response themes emerged from the last three interviews indicating that saturation was achieved (Sandino 2007).

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guiding the interview. It allows interviewers to be able to freely explore respondents’ answers in a conversational style. This method encourages the participant to explain answers openly, providing rich data. (Patton 2002). This method was important because we not only wanted to determine whether AC members were for or against MAFR, we also wanted to deepen our inquiry to understand the reasons underlying their positions. We conducted a pilot interview with two AC members (a chair and a regular member from the same organization) using a preliminary questionnaire draft. We received constructive feedback and modified the questionnaire accordingly. The revised questionnaire is presented in ‘‘Appendix 1’’. Two interviewers (authors) were present at each interview. One interviewer lead the interview and the other took notes and ensured that the interview guide was being followed. The average interview duration was 1 h 18 min, ranging from a minimum of 41 min to a maximum of 2 h 17 min. All interviews were audiorecorded for subsequent transcription. We analyzed and coded each transcription to uncover underlying themes. We followed the procedures recommended by Creswell (2003) in analyzing the data. Using open coding (Strauss and Corbin 1998), data were coded into major categories by two authors independently and any discrepancies were resolved by discussion and negotiated consensus.

4 Results The results of our interviews are presented below. We first present the results of queries on MAFR and how participants currently monitor auditor independence (Sect. 4.1). Next, we report participants’ views on audit partner rotation (Sect. 4.2), followed by AC perspectives on their relationships with financial management and with auditors (Sect. 4.3). Finally, AC perspectives on the costs associated with switching audit firms are presented (Sect. 4.4). 4.1 AC perspectives on MAFR All 19 (100 %) AC members interviewed in this study were against any form of MAFR. Twelve participants (63 %) stated that the AC has the authority to make switching decisions and they wish to retain and exercise this right if and when they believe a change is necessary and in the best interests of the company—as opposed to being forced to switch by a regulation. The notion of MAFR was perceived as a threat to the AC’s shareholder-granted authority and autonomy. Relevant excerpts follow: Participant 10: I am allergic to being forced to change anything…Being an entrepreneur by trade, I do not agree with government intervention to force [firm] rotation…it should not be imposed by the government…each time the government intervenes it takes away the little bit of autonomy that exists already in public

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companies…the AC should be able to judge if we need to make an auditor change. Participant 6: I’m dead against it! It’s the mandatory aspect that I think is the issue. Participant 2: I am not in favor of MAFR. I think companies and their shareholders through the board should have the authority to change the auditors, if one day they decide that should be done. Participant 18: We, as an AC, we can change – we do not need laws. We changed for all sorts of reasons [in the past] and we didn’t need a law…we changed due to a restatement…a question of communication, this is essential. Participant 8: MAFR is never welcomed by the AC, because it’s forcing a situation. I would like to remain responsible regarding the relationship that exists as the chair of the AC. I would like to keep my responsibility and my authority and I say this with a great deal of humility. But to exercise a role you need a little bit of power to choose my audit partner, to assure that the relationship between my auditor and the partner that signs the financial statements and the CFO is conducted the best way to ensure independence. And this I want to keep. Although they understood the objective of MAFR in enhancing auditor independence, fourteen (74 %) participants stated that there are other more effective safeguards to ensure auditor independence such as formal and informal communications with auditors and management to assess the nature of their relationship. The possibility of auditors and auditees in long-term cooperative relationships did not seem to concern participants. Related excerpts on ways in which ACs monitor auditor independence follow: Participant 13: …the call for MAFR it is fundamentally inappropriate. There are all sorts of ways to do that better. It adds a bunch of unnecessary process to a situation…it starts with a perception that the auditors have lost independence and need to be rotated periodically. That can be achieved in a more constructive format. It’s a very negative approach… …look the auditor in the eye when management is not there and you ask them a very direct question – what is your relationship with management? And you can ask management are the auditors asking you the right questions?…it’s pretty easy to tell if there is an issue with independence.

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Participant 9: Asking questions to our CFO, if there is even the slightest problem with your auditor, you will know quickly, because if you establish a good relationship as an AC member with your CFO, during vivacious conversations you will hear about them. And at the same time with your auditor, we will ask how is it going with the finance group and then they share the information because in camera (private meeting) people trust that the information will stay there…you don’t ask a question directly about independence. Participant 8: …I have a constant relationship with my auditors every quarter and yearly. So I am capable of judging the competence of who is in front of me…asking the right questions…it’s easy for me to measure independence… The following excerpt illustrates how one participant identified a potential auditor independence issue and took action: Participant 12: …you start with the assumption that they are independent to each other…you look for indicators that they are not, that they are actually too close. So one of the issues over here was that I set a lunch to meet a new audit partner and she phoned to cancel the lunch the morning of the lunch and she said she couldn’t have lunch because she hadn’t cleared it with the CFO. That was her last day on the file. You don’t clear my lunch with the CFO. I am the chair of the AC. This happened and I said goodbye. She’s not independent. 4.2 AC perspectives on audit partner rotation When asked about audit partner rotation, fourteen participants (74 %) felt that partner rotation provides for a more skeptical perspective by means of a new set of eyes, and believed that the that management-auditor relationship has more to do with the audit firm than with the lead partner. Participants seemed to appreciate the way in which audit firms transition lead partners as this transition process appears to effectively transfer knowledge and preserve the management-auditor relationship. Relevant excerpts follow: Participant 6: Yes I am in favor because you maintain the continuity of knowledge, but you have new eyes coming in watching from a new perspective… Participant 12: It’s the independence of thinking and your mind gets lazy…It’s independence of thought. Sooner or later our mind gets lazy. You are not questioning, you are not as skeptical. I think a fresh mind is good…

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Participant 19: Certainly as a CFO it is sad to see the lead partner leave because of this rotation but I believe it is advantageous because this assures certain independence with the arrival of the new partner. Participant 2: …I don’t disagree…I think it does send a signal, for independence it’s a good thing. My reason is not the same as the firm rotation…When you talk about the lead partner it gets personal. So you have the lead partner in a relationship with the CEO and with the CFO, and that can become almost very friendly, personal, they can become personal friends. And firms themselves, I think have an interest, should have an interest, in ensuring that the lead partner doesn’t get too cozy over time with top management. So if the firms do that well, that’s why I think there is less need for MAFR. Participant 11: …from a practical perspective, I’m not opposed to it. For independence, it’s always good to have a reality check…it could get too cozy and it would be hard for the auditor to maintain his independence because you can push on as a client…say I want to disclose this way…I want this policy in place…if they (audit firm) manage the transition properly it’s less onerous on me because at least I can transition that relationship to the new guy. I’m still going to call the old partner if I have a good relationship and I’m going to ask him questions in terms of high level accounting questions. However, not all participants were so supportive of mandatory partner rotation: Participant 9: …just keep the audit team in place since they are the executors…they have the intimate knowledge of the day to day. Participant 3: …it’s too bad sometimes. The people have a great relationship, they know the business inside and out…but the firm that has a good succession plan to service, its client will not suffer…if there has to be a rotation this is okay but not the whole firm…it is very disruptive and economically pointless… 4.3 AC perspectives on their relationships with financial management and with auditors Participants stressed the importance of creating an environment in which both management and auditors know that they can trust the AC with information: Participant 15: You have to have a good, open and honest relationship with the auditor and management. You know I meet with them regularly, I meet with them before

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every meeting…and you know the way I work with the auditors is that you can tell me things, I’m not going to go right back to management… Two AC chairs conceptualized their relationships with company management and external auditors as a triangular relationship6: Participant 8: I will meet with auditors if I have a doubt, a problem. Plus if there is a problem, the auditor will call me…already there is a tight relationship between the CFO and his team and the auditor, but also between the auditor and me as chair of the AC…it’s important that there is a triangle…between the CFO, auditor and me. When I say me, it is always as chair of the AC because at the AC we will review everything for proper oversight. That’s me – it’s my practice, yes. That is not obligatory. Participant 13: …as AC chair I have a direct relationship with the audit partner, not including management, a direct conversational relationship where we can talk about the issues that come up. You don’t want to be talking about too much around management, you want to be in a triangle but each side has to work. The AC chair sets the tone and climate of the relationships through openness and availability. Different AC chairs may have different management styles but, regardless of style, respondents indicated that both the auditor and financial management should know that it is easy for them to contact the AC chair: Participant 18: Regarding informal meetings…each chair has their own method…my way is the following…I say to the CFO and external auditor, I say to them I am available anytime you want to talk and I am easy to reach. Secondly, if there is something out of the ordinary, before the meeting with the AC I want you to call me to meet…the people need to feel at ease. Participant 2: …..we meet with the auditors at AC meetings at least six times a year…but as the chair I meet with the auditors every time before the meeting as well, so that helps me as chair to anticipate what issues might be to better discuss before the AC meeting itself. So they can talk freely…So when I say that I meet with auditors, I meet them as part of the committee meeting but I also meet them privately before the committee meetings…as every AC chair will tell you the same thing, there is an unwritten protocol between the external auditors and the chair of the AC. If there is anything going on you pick up the phone and you call. It is essential that there is easy communication between the chair of the AC and the external auditors, both in formal meetings and also outside the formal meetings. 6

We expand on and illustrate this conceptualization in a subsequent section.

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Participants (especially AC chairs) not only manage their separate relationships with financial management (e.g., CFO) and the external auditor, they also are concerned about the relationship between financial management and the auditor. Participants indicated that the management-auditor relationship was an important aspect of value-added audit service. The auditor and financial management must be independent but they also must work together cooperatively: Participant 3: …communication is important, it’s not just the level of independence, the lack of coziness, but it is also important that they work productively together to solve the issues, particularly for companies where the business is complex. Participant 9: …we are always interested in the [management-auditor] relationship because we want the relationship to be healthy but still objective. Participant 12: …every year we do a quality review of the auditor. The most important thing is even though the auditors report to the AC they spend 99 percent of their time with management not with the AC. They see us six times a year for two hours…they are on their best behavior…it’s the interaction with the management team that determines whether the noise level is OK. 4.4 AC perspectives on costs associated with audit firm changes All participants (100 %) emphasized the tremendous time and effort involved with changing audit firms. However, most respondents said that these switching costs would not influence their decision to change audit firms: Participant 10: …the cost is the time because you must decide which firms to invite [to bid]…then you need to fill out a workbook, a tendering workbook, and then you need to prepare a data room… Participant 2: …people that are promoting automatic rotation may not be sensitive to that cost (time), and this is not the cost of the audit fee itself…the [new] auditors have to ask questions, ask for information, documentation to understand how particular parts of the business work, why you have chosen this particular accounting procedure…the time that management needs to spend with the new auditors…that’s the biggest issue…you don’t normally capture that cost…yet that kind of cost can be a detriment, a factor that can discourage companies from considering switching. Participant 19: …to change firms is very disruptive and breaks the continuity…

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Participant 8: …to deal with a firm today starting at zero and no [client-specific] knowledge…it’s the learning curve and very expensive…the firm must familiarize itself with the company, but to do a good audit it’s not just to familiarize with the company, you need to know the industry in which the company works to really understand the inherent risk…it’s learning…lots of learning…

5 Discussion AC members in this study overwhelming felt that there are enough safeguards already in place in Canada to maintain auditor independence and objectivity without implementing MAFR. These safeguards include mandatory audit partner rotation every 7 years with a five-year cooling off period (CPAB 2012), of which most participants approved. All 19 AC members in this study were adamantly opposed to MAFR. According to self-determination theory (Deci and Ryan 1985, 2000), autonomy is an innate psychological need that is enhanced by intrinsic motivators such as the ability to influence. Using this theory, Boivie et al. (2012) find that the ability to influence organizational outcomes is a significant motivator for AC members. As such, self-determination theory is a useful framework for interpreting the results of our interviews. The interviews reveal that the desire for autonomy and the ability to influence are indeed important to AC members and likely shape their perspectives on MAFR. Relevant excerpts from participants include: ‘‘each time the government intervenes it takes away autonomy’’, ‘‘…the board should have the authority to change auditors’’, and ‘‘I would like to keep my responsibility and my authority.’’ AC members view MAFR as a threat to their autonomy and ability to influence audit firm appointment decisions and are therefore opposed to it. Some participants described their relationships with external auditors and financial management as triangular. Informed by the results of our interviews and regulatory requirements, a conceptual model of the relationships between ACs, auditors, and financial management is presented in Fig. 1.7 AC members (especially chairs) are responsible for the maintenance of three independent relationships. Paths A and B in Fig. 1 represent the AC’s separate relationships with the audit firm and financial management, respectively. Several AC members highlighted the importance of trust, openness, and availability in fostering quality relationships with both auditors and management. The perception of ‘‘availability’’ seems to be an important element of high-quality relationships in an accounting environment. In an interview study, Fontaine et al. (2013) find CFO perceptions of auditor availability to be a critical element in quality auditor–client relationships. 7

Not depicted in Figure 1 is the AC’s direct relationship with internal auditors. A suggestion for future research is offered in a subsequent section.

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Audit Committee

A

B D

Financial Management

External Audit Firm C

Fig. 1 A conceptual model of the relationships between the Audit committee, Financial management, and external Auditor

In addition, respondents emphasized how ACs must also oversee the auditormanagement relationship (path C in Fig. 1).8 AC members must ensure that this relationship is simultaneously independent and productive and resolve any disagreements between the auditors and management (Canadian Securities Administrators 2004). AC oversight of the auditor–client relationship is depicted as the dotted path D. The AC uses formal and informal communication methods to detect any issues that might indicate impaired independence between auditors and management. Interestingly, the AC’s professional judgment in assessing independence was the most cited safeguard against impaired auditor independence and objectivity. This theme was cited more frequently than other safeguards such as mandatory partner rotation and CPAB or PCAOB inspections.

6 Conclusion This study examined AC perspectives on MAFR, mandatory audit partner rotation, ways in which audit committees monitor auditor independence and objectivity, and switching costs. Interview results and regulatory requirements were used to develop a model of AC relationships with auditors and financial management. Participants indicated that the most significant cost associated with changing auditors is the time and effort involved in the tendering process and in bringing a new auditor up to speed with client- and industry-specific knowledge. The central topic of this paper is MAFR. The interviews indicate that, although most AC members favor partner rotation, all were adamantly opposed to MAFR. MAFR was perceived as a threat to the AC’s shareholder-granted autonomy and authority, and respondents indicated that their own judgment and observations were the most effective means of ensuring auditor independence and objectivity. These results are explained by selfdetermination theory. Understanding the attitudes and behavior of AC members is critical since the AC is charged with overseeing financial reporting and disclosure. These individuals are 8

Herda and Lavelle (2013) find that perceptions of fair treatment and support between auditors and clients lead to strong but independent auditor–client relationships.

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empowered to make audit firm selection decisions and, if desired, to implement an audit firm rotation program voluntarily. Prior literature documents that an overwhelming majority of AC members oppose MAFR (Ernst and Young 2012). However, explanations behind this opposition were limited to relatively short signed comment letters submitted to the PCAOB. This paper contributes to the literature by providing deep insight into AC members’ perspectives on MAFR. In-person interviews and guaranteed anonymity were used to elicit candid responses to questions on MAFR. Different communication channels and methods can influence individuals’ responses to topics (Holstein and Gubrium 1997). To illustrate, based on a review of 238 comment letters from AC members to the PCAOB, an increase in costs was the most cited reason for AC members’ opposition to MAFR (Ernst and Young 2012). However, cost was not the most cited reason in our interviews. Participants were quick to discuss their authority as AC members. Fourteen (74 %) respondents stated that the AC itself was better equipped to ensure auditor independence and objectivity (compared to a rotation rule) and wanted to retain their authority and autonomy in this capacity. Indeed, most participants did not even mention costs until we specifically asked questions on switching costs later in the interview. Costs outweighing benefits is almost a canned response. Our interviews revealed the fundamental reason why ACs oppose MAFR—they do not want to lose their autonomous ability to influence audit firm appointment decisions as explained by self-determination theory. This study has limitations. First, our conceptual model (Fig. 1) should be interpreted with caution in light of the relatively limited number of interviews upon which it was built. Next, this paper does not provide information on the involvement of ACs in the monitoring of internal auditors or on how the AC-internal audit relationship might affect the AC’s relationships with financial management and with external auditors. Future research could address this topic and also examine how internal auditors affect the relationship between financial management and external auditors—a relationship that ACs must monitor. Our interview results indicated that AC chairs have their own individual approaches in managing their relationships with both management and external auditors. Future research could investigate the impact of personal styles and characteristics on these relationships and the effectiveness of different approaches. Future research could examine ways in which perceptions of trust, openness, and availability are developed and maintained among the parties from the perspectives of AC members, financial management, and external auditors. Future research could also empirically explore the added value for the auditee resulting from a long relationship with the auditor by examining the synergies (e.g., trust or competence) that can develop between the AC, management, and auditor. Synergies may not necessarily imply impaired auditor independence. Acknowledgments We thank Roberto Di Pietra (editor), our interview participants, and the two anonymous reviewers for their helpful comments and suggestions. We are also grateful for the generous support provided by the Corporate Reporting Chair of the Accounting Department at the University of Quebec at Montreal. We would like to dedicate this article to our colleague and dear friend, Glenn Rioux. Thank you for your help Glenn, you will be truly missed.

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Appendix: Interview questionnaire Panel 1: Mandatory rotation and overseeing the auditor-management relationship 1. 2. 3.

What do you think about mandatory audit firm rotation? What do you think about mandatory audit partner rotation? Has your audit committee ever discussed the possibility of a corporate policy for audit firm rotation? Why or why not? What discussions have you had regarding the importance of auditor independence? Have you had any problems with auditor independence? What mechanisms do you use to ensure auditor independence? How do you manage the relationship between the external auditor and management? Describe your relationship with the external auditor. How many times a year do you meet with the external auditor? Describe your relationship with management. How frequently do you meet with management? How much input does management have in audit firm selection decisions? How important is a good relationship between the external auditor and management? How important is independence between the external auditor and management? How important is the management letter provided by the external auditors?

4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

Panel 2: Switching costs 1. 2. 3. 4. 5. 6.

How difficult would it be for your company to change auditors? (effort, time, and other possible constraints). Would these constraints stop you from changing? How difficult would it be for your management team to adjust to the new auditors? Describe the main costs (monetary and other) associated with changing firms. What is keeping you with the current audit firm? What would cause you to change auditors?

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